XP Power — Adapting to tougher trading conditions

In H119, XP reported a 6.1% revenue increase year-on-year; in constant currency, revenues were flat. Own design revenues also increased 6% y-o-y, making up 78% of total revenues (flat versus H118). On a reported basis, the gross margin declined 210bp and on a constant currency basis 150bp. The margin declined as a result of the tariffs in place between the US and China, adverse product and geographic mix and component price inflation, which started in 2018. The company is working with customers to minimise the impact of the tariffs and hopes to see the benefit in H2.

The company implemented IFRS16 from 1 January 2019, so EBITDA was positively affected by the exclusion of lease expenses. At the adjusted operating profit line, the effect was minimal as this included increased depreciation on right of use assets. The adjusted operating margin decline tracked the decline in gross margin and also felt the impact of higher underlying operating costs (+11.6% y-o-y) as the company increased investment in product development. Gross product development spend of £8.9m increased 35% y-o-y, before the capitalisation of £4.4m of costs, with net spend including amortisation 21% higher y-o-y.

The company reported exceptional items totalling £2.1m: £0.4m relating to acquisitions, £0.5m relating to the ongoing ERP upgrade and £1.2m on a legal dispute in the US (not customer-related) which is currently going through mediation.

The company announced a Q2 dividend of 18p per share (in line with our forecast), which is due to be paid on 10 October. Net debt (excluding £5.7m in lease liabilities) increased y-o-y, but was down from the £52.0m reported at the end of FY18. Net cash from operations of £25.2m benefited from the unwind of some excess inventory (built last year to counter component shortages).

As already highlighted by the company in its April trading update, XP’s fortunes were mixed in H119. In the semiconductor production equipment (SPE) segment, demand was weak as chip manufacturers continued to work through excess inventory of memory chips. Conversely, all other end markets saw growth on a year-on-year basis. As most SPE customers are based in the US, this region saw a small decline over the period on a reported basis (-8% in constant currency, -14% on an organic basis) whereas all other regions grew.

Revenues from SPE customers were down 29.7% on a reported basis or 34% on a US dollar basis. Excluding the contribution from Glassman ($5.3m in H119, $1.0m in H118), underlying dollar-based revenues declined 48% y-o-y compared to growth of 68% in 2018. The company does not expect a pick-up in demand from this sector until 2020.

Revenues from the Industrial sector were 21% higher on a reported basis and 13% higher on a US dollar basis. Healthcare sector revenues were 16% higher on a reported basis and 8% higher on a US dollar basis. Technology sector revenues were 20% higher on a reported basis and 12% higher on a US dollar basis.

XP has been hit by the double whammy of reduced demand from SPE suppliers and tariffs on trade between the US and China (in both directions). It has undertaken various measures to mitigate the impact on the business, outlined below.

XP recently expanded its Vietnamese manufacturing facility (completed in Q119) and was already in the process of moving production of less complex power converters (sub 1.5kW) from China to Vietnam. With US tariffs on the import of components manufactured in China rising from 10% to 25% in Q2, XP has accelerated this shift. Over the last 12 months, the Vietnam facility has grown the number of products it is able to manufacture from 282 to 1,819. In H119, 779,800 converters were manufactured across both sites, of which 79% were made in Vietnam. This compares to 716,900 converters in H118, of which 70% were manufactured in Vietnam. We expect the volumes produced in Vietnam to continue to increase as more customers qualify the facility.

The company intends to maintain its China facility, as this is used for some of the more complex converters and is also useful for the production of converters for Chinese customers, who will otherwise incur tariffs of 15% on products imported from the US.

The company has decided to restructure the manufacture of low power, high voltage DC-DC modules from the Minden facility in Nevada to Vietnam. The US facility will be closed by June 2020. XP expects to save c £4m pa once the transition is complete (of which it expects to reinvest £1–2m to expand the new product introduction team), with expected one-off costs of £1–2m.

In 2018, the company saw lead times lengthen for key components such as MOSFETs and multilayer surface mount capacitors. To counter this, it built up buffer stock of the most important components which were at higher than typical prices. So far this year, it has seen lead times reduce for some, but not all components. The level of safety stock has therefore been reduced (inventory stood at £51.2m at the end of H119 versus £56.5m at the end of FY18), although is still relatively high compared to the level at the end of 2017 (days sales outstanding: FY17 83, FY18 106, H119 94).

The company expects Brexit to have limited operational implications. In Q119, it implemented its no-deal Brexit contingency plan which involved transferring inventory for 15 key accounts out of the UK warehouse to XP’s German warehouse. The company believes that some customers may have brought forward orders and increased inventories to prepare for Brexit, but does not estimate that this has had a substantial impact on trading.

XP received orders worth £100.6m in H119, down 1% y-o-y and down 7% in constant currency. In constant currency on a geographic basis, orders increased 11% y-o-y in Asia, 1% in Europe and declined by 12% in North America (19% organic). Book-to-bill for H119 was 1.02x and the company entered H219 with an order book worth £86.1m, 5.6% higher than at the start of the year. On a quarterly basis, Q119 orders of £54.6m were 6.6% higher y-o-y and 21.1% higher q-o-q. Q219 orders of £46.0m were 8.4% lower y-o-y and 15.8% lower q-o-q.

The company expects to see improved revenue performance in H2. When the SPE sector starts to recover (not expected by XP until 2020), we believe the company is in a good position to receive production orders as it has won recent design slots. Work underway to transfer production to Vietnam, as well as the possibility of clawing back some tariffs from customers, should improve margins in H2, while the closure of the Minden facility in 2020 should boost FY20 margins.

We have left our revenue forecasts unchanged. For FY20, we have reduced our gross margin forecast to reflect the various cost pressures. We have reflected the implementation of IFRS16 – this increases EBITDA (as lease costs are excluded) and increases depreciation (on the newly created £5.5m of right of use assets), but has a minimal impact on operating profit. We have also amended our capex and depreciation and amortisation forecasts to reflect costs incurred in H119. As the net finance cost was £1.6m in H119 (including £0.1m relating to IFRS16), we have increased our net finance cost forecasts from £1.8m to £3.2m in FY19 and £1.8m to £3.0m in FY20. Overall, this results in normalised diluted EPS reducing by 4.4% in FY19 and 4.0% in FY20.

The stock ran up from 2,140p at the end of 2018 to 2,670p in April on the back of the positive Q1 trading update and expectations that the semiconductor sector was close to bottoming out. Since then, S301 tariffs in the US have increased from 10% to 25%, and semiconductor companies have not yet shown sustained signs of recovery. The stock is now down 24% from the peak in April and down 5% year-to-date. The discount to peers has widened and XP trades at a more than 30% discount to both power converter and UK electronics peers on an FY20e P/E basis, with a dividend yield at the top end of the range. With a broad product portfolio focused on structural growth markets, local customer support, control over the manufacturing process and strong cash generation, we view the company as well positioned to grow market share. Work on optimising the supply chain should help the company to grow while generating strong operating margins. Key triggers for share price upside from this point include evidence of order growth from the semiconductor equipment sector and a moderation in tariffs between the US and China.